Syracuse, NY — The Internal Revenue Service's audit rate for wealthy Americans sharply declined in the just-ended fiscal year, according to agency data obtained by the Transactional Record Access Clearinghouse (TRAC).

The significant turndown in audits for richer Americans from FY 2007 to FY 2008 sharply contrasts with the IRS claim in a 2008 press release boasting that the agency was making "strong progress in a number of key enforcement areas," especially for "those with incomes of $1 million or more."

The IRS data clearly show that the audit rate on the 300,000-plus returns reporting incomes of more than $1 million was substantially down last year — dropping at least 19 percent. But because of admitted agency accounting errors and two sets of conflicting numbers the IRS published just last Friday (March 13, 2009), the actual extent of this decline may be much larger.

Given the lag between the year that income is received, a return is filed, and then becomes subject to audit, the drop in the audits occurred for those returns with income earned at the height of the real estate boom, just before the economy turned sour.

And similar to many of the corporate financial reports of that era, the audit numbers that the IRS was so loudly trumpeting have turned out to be based upon inaccurate data drawn from the agency's own books.

An Unconvincing Explanation Given the opportunity to respond prior to the publication of this report, the IRS chose not to explain its policies in reducing the rate of millionaire audits by at least 19 percent this past year. However, according to a Bloomberg News article, IRS spokesperson Terry Lemons commented: "Audit rates were down slightly in 2008 due to a variety of factors, including implementing stimulus last year." This explanation is curious since the agency's own figures show that the IRS managed to maintain or increase the number of correspondence audits for income groups other than millionaires, where the number of such audits fell by 12 percent last year. Those with total positive income less than $200,000 experienced no change in correspondence audit levels, while those between $200,000 and $1 million total positive income experienced a 15 percent increase in the number of such audits last year (see Table A). The logic of the decision of IRS managers to switch agency campus auditors from millionaire audits to processing stimulus checks seems even more questionable, as the audits of millionaires tend to uncover more misreporting dollars than other groups (see Table 3) and constitute the fastest growing return class (see Table A). Table A. IRS Fiscal Year 2008 Enforcement Results Income Level Correspondence Audits Returns Filed FY 2007 FY 2008 Change FY 2007 FY 2008 Change $1 Million and Higher 10,941 9,641 -12% 339,138 392,776 16% From $200,000 up to $1 Million 58,524 67,535 15% 3,603,564 4,049,380 12% Less than $200,000 1,003,759 1,003,976 0% 130,600,177 133,407,479 2% Data source:IRS Fiscal Year 2008 Enforcement Results

Last Year's Audits of Millionaires Down Sharply

IRS figures released to TRAC indicate that agency audits of taxpayers reporting a total positive income of one million dollars or more — involving both face-to-face audits and agency correspondence contacts — fell to only 5.6 per 100 returns filed in FY 2008. This rate would represent a 19 percent drop from the previous year. The full extent of the decline was formally confirmed this past Friday by IRS spokesman Frank Keith.

On that very day, however, the IRS published on its web site a second set of figures suggesting that the millionaire audit rates last year may have plummeted even more than the spokesman had just asserted. These new figures reported that only 4.4 (not 5.6) out of every 100 returns with a million or more in adjusted gross income had been audited last year. This figure would indicate that in the last year the millionaire audit rate actually had declined by at least a 36 percent (see Table 1).

Face-to-face audit rates for this group have sunk to at best the same level they were five years ago, before the IRS announced it intended to target these high income tax returns for increased scrutiny. Now only around 3 out of every 100 returns received regular audits (see Table 2).

In the face of growing federal deficits and public calls to lower the tax gap — the amount of taxes due but not reported and paid — the drop in millionaire audits is surprising. As one might expect, according to the additional taxes that IRS revenue agents found were owed after completing their audits, no other class of individual tax returns comes close in terms of the size of the underreporting errors. Last year, for example, the average IRS audit of the millionaire class of taxpayers resulted in agent recommendation of just under $200,000 in additional taxes for each return. Even for the much less intensive correspondence audit contacts — which from start to finish typically require only a little over two hours to complete — the auditor recommendations for additional taxes averaged over $136,000 per return (see Table 3).

While the actual number of this group of audits declined last year, the resulting drop in the audit rate was much larger. This is because in the space of five years the millionaire class doubled — from only 190,000 to over 392,000.

The Shocking Failure in IRS Accounts

Just a year ago the IRS was boasting that its drive to focus increased attention on those reporting at least a million dollars in income was in high gear. The agency's January 2008 press release declared: "Audit of individuals with incomes of $1 million or more increased from 17,015 during FY 2006 to 31,382 during fiscal year 2007, an increase of 84%."

But now, many months after the event, the IRS for the first time has publicly confirmed that both its 2006 and 2007 audit numbers have had to be revised sharply downward because of "misreporting" discovered in the agency's books. As it turns out, it now appears that the 2006 audit numbers had been inflated by 20 percent while the 2007 audit number that the IRS had boasted about had been inflated by 35 percent over actual levels (see detail table).

In response to TRAC's inquiries, Keith responded:

We discovered a coding error in how some of the returns were categorized. This led us to revise downward the $1 million category for previous years.

While the IRS Data Book including the 2008 figures was posted just last Friday, the substantial adjustment was not noted in a press release or even a footnote calling attention to the significant correction. Keith informed TRAC that plans to update its inflated 2007 figures was a full year away.

Under law and extensive IRS regulations, all taxpayers are of course obligated to fully and accurately account for their liabilities. It is this reality that makes the failure of the agency to properly track the number of millionaire tax returns that it has audited so disturbing. The concern is underlined by the errors that have recently been discovered in the tax returns of several of the those that President Obama had nominated for top positions in his administration. This raises the following question: would more aggressive auditing of millionaires in the last few years have headed off some of these problems?

Lack of IRS Transparency

The IRS has not been responsive to several TRAC requests to interview knowledgeable agency officials about how such a serious problem in its own accounts — and in such a high profile program — could have gone undetected for so long. The agency has also not responded to TRAC questions on whether managers were receiving regular monthly reports tracking millionaire audits during this period.

The core error appears to have occurred in the agency's tracking of correspondence audits at IRS campuses (formerly called Service Centers). Monthly management reports prepared about the correspondence audits by the IRS's older mainframe computing systems do not contain any information analyzing the audits by taxpayer income classes. However, it remains unclear whether the IRS's newer AIMS Computer Information System (A-CIS) set up on a more modern platform has been providing managers with reports tracking millionaire audits over the period where these large misreporting problems occurred.

TRAC has been seeking samples of the audit reports prepared under the newer system since 2004. This effort has not been successful, despite an existing court order requiring the production of these records. Last year, TRAC's co-director, Susan Long, returned to court and obtained an order that required the agency to produce each regularly generated A-CIS report. While IRS attorneys initially resisted the entry of this court order, once the judge had instructed it to provide the reports, they shifted their argument and informed Long's attorney that their new system did not regularly generate them. Instead, they now said, the A-CIS system was only used to handle "ad hoc queries." Thus, the IRS now claims there is nothing to turn over.

Given the serious state of the nation's economy, the central role that the IRS plays in its regulation and the announced commitment of President Obama to a more transparent government, the belated admission of the IRS about its failure to accurately track its basic auditing practices is troubling. Underlining these concerns is an even broader question: has the agency's authority to demand careful and complete reporting by every American taxpayer — individual and corporate — been undermined by its own admitted failures?